Buy Side Eyes Derivatives Valuation

Terry Flanagan

Transparency is being pushed into derivatives markets on multiple fronts.

Buy-side firms are adjusting to revamped valuations that are key to the clearing and execution of over-the-counter (OTC) derivatives, as Dodd-Frank and the European Market Infrastructure Regulation mandates move forward.

The U.S. Securities Exchange Commission and other regulators have “made it clear they have high expectations for valuation model risk controls,” said Larry Levine, a partner at accounting firm McGladrey. “That’s been telegraphed to institutions.”

Getting the right pricing model and knowing whether it is subjective or objective is important, Levine said earlier this week on a webinar sponsored by Chicago Board Options Exchange. Regulators are forcing documentation of how the derivatives are valued, demanding “observable information from an external source to support the variables,” including transparency from accounting and operational points, added Levine.

For buy-side firms, challenges include whether to use independent valuation services or internal valuation models, whether to use exchange valuations, and gaining a clear understanding of the ways the methodologies differ. Valuing derivatives is complex, said Levine, citing the Office of the Comptroller of the U.S. Currency’s publication on model risk that is a reference on the subject. “There are pages of complicated formulas,” he said.

“If the valuation is not obtainable as a quoted price from an exchange or swaps execution facility, you can rely on a third-party vendor,” said CBOE’s Matthew McFarland. “You’re investing in their expertise on a particular derivative or asset class. Or you could use internal valuation models,” which are capital intensive, he said.

“Getting broker statements in a rationalized format has been a challenge; standardization among counterparty valuations would be great for the industry,” said Judson Baker, Northern Trust derivatives and collateral management officer, in the webinar.

“Northern Trust, as an asset servicing firm, uses an array of independent valuation services,” he said. Then, “take an independent view of the valuations and run controls.” This is how many firms are deploying to run their full OTC book and their exchange-traded book, if they participate in both markets, Baker said.

“Or you could use counterparty marking, though they have a bias,” McFarland added. Be suspicious of the ingredients if using someone else’s model, he noted, to ensure they are using the correct formulas for the specific derivative.

Baker agreed. “Know what drives that black box model for valuations. What volatilities and credit spreads are they using? Often, that information is not available to the buy-side counterparty,” he warned.

The Depository Trust & Clearing Corporation is the main trade repository, and many firms don’t know they have access to that information about themselves and the ability to pull reports on what valuations their dealers reported, the webinar speakers said.

A mid-webinar survey of the registrants showed about a third are using a combination of in-house or independent valuation services for non-exchange derivatives, while using exchanges’ valuations for listed derivatives.

One driver is collateral management. “To have your own view is perceived as a best practice at many firms,” stated Baker. And while you can’t dispute the margin calls, you can begin to challenge them over time.

Concerning the implications on collateral, McFarland noted the advantage of centralized clearing is that there is a net value for maintaining collateral but that the forms of permitted collateral are more stringent.

Buy-side firms also need to consider that central clearers have started with the most liquid and transparent derivatives, so the valuations are unlikely to vary from firms’ own valuations.  However, for CBOE’s Flex contracts, market makers are not required to continuously stream bids and offers as they do in Standards. “The illiquid and long-dated contracts are a completely different animal; all exchange prints are not created equal,” McFarland said.

The Options Clearing Corp. publishes Flex valuations daily but not until evening, so firms with NAV requirements may have to rely on another source, he stated.

McFarland said CBOE values Flex and OTC using the Customized Options Pricing Service (COPS) that derives valuations through surveys of market making firms at CBOE. The risk is that bids and offers can change, but they have robust algorithms to submit valuations, and CBOE produces an average daily valuation based on those submissions.

“True value is the traded price. In the absence of that, we rely on these valuations,” said the exchange director.


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